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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Form 10-K
Annual report pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the fiscal year ended: December 31, 1997 Commission file number: 811-6268
SBM Certificate Company
(Exact name of registrant as specified in its charter)
Minnesota 41-1671595
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
c/o ARM Financial Group, Inc.
515 West Market Street
Louisville, Kentucky 40202
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (502) 582-7900
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
X Yes No
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
As of February 15, 1998, 250,000 shares of the registrant's common stock
were outstanding. The registrant is a wholly owned subsidiary and its common
stock is not traded on a public market.
DOCUMENTS INCORPORATED BY REFERENCE
None
The registrant meets the conditions set forth in General Instruction I (1)
(a) and (b) of Form 10-K and is therefore filing this Form with the reduced
disclosure format.
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TABLE OF CONTENTS
Item Page
- ---- ----
PART I
1. Business...................................................................3
2. Properties.................................................................4
3. Legal Proceedings..........................................................5
4. Submission of Matters to a Vote of Security Holders........................5
PART II
5. Market for Registrant's Common Equity
and Related Stockholder Matters..........................................6
6. Selected Financial Data....................................................6
7. Management's Discussion and Analysis of
Financial Condition and Results of Operations............................6
8. Financial Statements and Supplementary Data...............................11
9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure..................................11
PART III
10. Directors and Executive Officers of the Registrant........................12
11. Executive Compensation....................................................12
12. Security Ownership of Certain Beneficial Owners and Management............12
13. Certain Relationships and Related Transactions............................12
PART IV
14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K..........13
Signatures................................................................15
Index to Financial Statements............................................F-1
2
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PART I
Item 1. Business
(a) General Development of Business
SBM Certificate Company (the "Company") was incorporated in
Minnesota in June of 1990, to assume the face-amount certificate business
of SBM Company ("SBM"). Effective December 31, 1993, SBM transferred all
of the Company's shares of common stock to its wholly owned subsidiary,
State Bond and Mortgage Life Insurance Company ("SBM Life"). On June 14,
1995, the Company became a wholly owned subsidiary of ARM Financial Group,
Inc. ("ARM") pursuant to ARM's purchase of substantially all of the assets
and business operations of SBM (the "Acquisition"). ARM specializes in the
asset accumulation business, providing retail and institutional customers
with a variety of products and services designed to serve the growing
long-term savings and retirement markets. At December 31, 1997, ARM had
$6.9 billion of assets under management.
(b) Financial Information About Industry Segments.
The Company has one business segment.
(c) Narrative Description of Business
The Company is an issuer of fixed-rate face-amount certificates
registered under the Investment Company Act of 1940, as amended (the "1940
Act"). A face-amount certificate is an obligation of the Company requiring
the Company to pay certificate holders the original invested amount of the
certificate, plus a three-year fixed-rate return, at a given maturity
date. The Company selects the interest rate offered on the face-amount
certificates based on the short to intermediate term sections of the yield
curve. Face-amount certificates, which are similar to bank certificates of
deposit, generally compete with various types of individual savings
products offered by banks and insurance companies that provide a fixed
rate of return on investors' money. The Company's face-amount certificates
are sold primarily in the Midwest.
The Company's face-amount certificates are distributed by ARM
Securities Corporation ("ARM Securities"), a wholly owned subsidiary of
ARM, pursuant to an Underwriting Agreement. Prior to November 29, 1996,
ARM Securities operated under the name SBM Financial Services, Inc. ARM
Securities currently uses a network of independent agents to sell and
service the business. The Company continues to investigate opportunities
to expand upon its distribution channels. ARM Securities is registered
with the Securities and Exchange Commission (the "SEC") as a broker-dealer
under the provisions of the Securities Exchange Act of 1934, as amended.
The Company's gross margin is derived primarily from the margin
between earnings on investments and amounts paid or credited on its
fixed-rate certificate deposits ("net investment spread"). The Company's
net income is determined by deducting investment and other expenses and
federal income taxes from gross margin. The net investment spread is
affected by general economic conditions, government monetary policy, the
policies of regulatory authorities that influence market interest rates,
and the Company's ability to respond to changes in such rates. Changes in
market interest rates may have a negative impact on the Company's
earnings.
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The Company's face-amount certificate business competes in general
with various types of individual savings products which offer a fixed rate
of return on investors' money, especially insurance and bank products.
Some of these other products are insured by governmental agencies or funds
or independent third parties. The certificates offered by the Company are
not guaranteed or insured by any governmental agency or fund or
independent third party. The Company's business is highly competitive and
the Company competes with many other companies having greater financial
resources, larger sales forces, and greater access to customers. The
Company's ability to offer competitive interest rates, attractive terms,
and efficient service are the Company's primary basis for meeting
competition. The Company has no employees. Pursuant to an Investment
Services Agreement and an Administrative Services Agreement, the Company's
operations are managed by ARM.
Like many financial services companies which offer investment
opportunities to the public, the Company is subject to regulation and
supervision by federal and state regulators. The 1940 Act and rules issued
by the SEC thereunder specify certain terms for face-amount certificates,
the method for calculating reserve liabilities on outstanding
certificates, the minimum amounts and types of investments to be deposited
with a qualified custodian to support such reserve liabilities, and a
variety of other restrictions on the operation and governance of a
face-amount certificate company. Pursuant to statutory authority, the
Minnesota Department of Commerce ("MDC") and the Illinois Secretary of
State exercise supervisory powers over the Company's face-amount
certificate business similar to those under the 1940 Act. In addition, the
MDC conducts examinations of the Company on a periodic basis. The offer
and sale of the Company's face-amount certificates also are subject to
federal and state securities laws.
(d) Financial Information About Foreign and Domestic Operations and Export
Sales
The Company has no foreign operations.
Item 2. Properties
The Company's and ARM's corporate executive offices (the "Corporate
Offices") are located at 515 West Market Street, Louisville, Kentucky. The
Corporate Offices are the location of the Company's executive officers and the
primary location for ARM's accounting, legal and marketing activities and
various other support personnel.
The Company's administrative offices are located in New Ulm, Minnesota, at
100 North Minnesota Street, in a building owned by the Company. The building has
a total office space of approximately 49,000 square feet. A significant portion
of the building (approximately 15,000 square feet) is leased exclusively to
State Bank & Trust Company of New Ulm, a former subsidiary of SBM. Parts of the
building are leased to other persons.
4
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Item 3. Legal Proceedings
The Company is not a party to, nor is any of the Company's property the
subject of, any material pending legal proceedings, other than ordinary
litigation routine to the Company's business.
Item 4. Submission of Matters to a Vote of Security Holders
This information is omitted in accordance with Instruction (I)(2)(c) to
Form 10-K.
5
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PART II
Item 5. Market for the Registrant's Common Equity and Related Stockholder
Matters
There is currently no public market or trading in the common stock of the
Company. All of the Company's 250,000 outstanding shares of common stock are
held by ARM as of December 31, 1997. The Company has never paid cash dividends
on its common stock.
The Company is subject to two principal restrictions on its ability to pay
dividends in addition to the generally applicable restrictions and requirements
of Minnesota corporate law. First, pursuant to Section 28(b) of the 1940 Act,
the Company is required to establish and maintain qualified assets having a
value not less than the aggregate of certificate reserves plus $250,000. Second,
the MDC has determined that face-amount certificate companies such as the
Company should maintain a ratio of shareholder's equity to total assets of a
minimum of 5%. For purposes of determining compliance with both requirements,
assets are based upon a valuation of available-for-sale securities reflected at
amortized cost. The Company could not pay dividends if it did not meet both of
these two requirements or if payment of a dividend would cause it not to meet
such requirements. As of December 31, 1997, the Company had qualified assets in
excess of certificate reserves plus $250,000 of $14.6 million and total assets
in excess of the 5% ratio of $1.9 million.
Item 6. Selected Financial Data
This information is omitted in accordance with Instruction (I)(2)(a) to
Form 10-K.
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations
General
The Company was acquired by ARM in connection with ARM's acquisition of
substantially all of the assets and business operations of SBM effective May 31,
1995. The results of operations for the year ended December 31, 1995 represent
the historical results of the Company for the period from January 1, 1995 to May
31, 1995 combined with the results of operations of the Company subsequent to
the Acquisition from June 1, 1995 to December 31, 1995. Historical results of
operations are not completely comparable with results of operations subsequent
to the Acquisition primarily due to differing asset/liability management
strategies and expense allocation methodologies of ARM and SBM management.
Therefore, results of operations for 1996 are not completely comparable with
1995.
6
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Results of Operations
1997 Compared with 1996
Net investment income (net income excluding net realized investment gains
and losses) was $258,205 and $414,670 for 1997 and 1996, respectively. The
decrease in net investment income was primarily attributable to a decrease in
net investment spread, partially offset by lower investment and other expenses
and lower federal income tax expense.
Net investment spread, which is the difference between investment income
and interest credited on certificate reserves, decreased to $1.1 million during
1997 from $1.5 million in 1996. These amounts reflect net investment spread of
1.63% and 2.28% during 1997 and 1996, respectively, between the Company's
investment yield on average cash and investments and the average rate credited
on certificate reserves. The Company's investment income decreased to $3.9
million from $4.3 million for 1997 and 1996, respectively. These amounts
represent investment yields of 7.43% and 7.78% on average cash and investments
of $51.3 million and $54.5 million for 1997 and 1996, respectively. This
decrease in investment yield on cash and investments was primarily attributable
to the Company selling its mortgage-backed derivative securities during the
last half of 1997 and reinvesting the proceeds when generally lower
reinvestment rates were available. As a result of this trading activity,
above normal average cash balances were held, further depressing the
investment yield.
Interest credited on certificate reserves was $2.8 million for both 1997
and 1996. These amounts represent average rates of interest credited of 5.80%
and 5.50% on average certificate reserves of $46.3 million and $50.4 million for
1997 and 1996, respectively. The majority of the Company's outstanding
face-amount certificates are fixed-rate three year contracts. The Company
monitors credited interest rates for new and renewal issues against competitive
products, mainly bank certificates of deposit. Credited interest rate
adjustments (up or down) on new certificates are made as the Company deems
necessary. New and renewal contracts issued during 1997 have crediting rates
that are generally higher than contracts that matured during 1997, resulting in
the overall increase in the average crediting rate.
Investment and other expenses were $755,256 and $815,094 for 1997 and
1996, respectively. The decrease in investment and other expenses is primarily
attributable to (i) a decrease in goodwill amortization, (ii) a decrease in real
estate expenses at the Company's Minnesota facility and (iii) a decrease in
other expenses which included decreases in annual regulatory examination expense
and filing fees. Such decreases were partially offset by an increase in renewal
commissions.
Realized investment losses were $268,002 for 1997 compared to realized
investment gains of $485,135 for 1996. Such realized investment gains and losses
were interest-rate and credit related and attributable to the asset/liability
management strategies of the Company. Fixed maturities and equity securities
(i.e., non-redeemable preferred stock) classified as available-for-sale are sold
during rising and falling interest rate environments which can result in
period-to-period swings in interest-rate related realized investment gains and
losses.
7
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During 1997, net income was $94,688 compared to $731,981 in 1996. The
decrease was primarily attributable to a decrease in realized investment gains
and net investment income.
Certificate reserves decreased $5.1 million or 10.1% during 1997, as
maturities and surrenders exceeded sales and renewals. The Company believes a
significant factor leading to the decrease is that the certificate of deposit
marketplace is currently very competitive. For certificates reaching their
maturity date during 1997 and 1996, 64% and 73%, respectively, were renewed.
1996 Compared with 1995
During 1996, net income was $731,981 compared to $776,739 in 1995. Net
investment income was $414,670 and $595,354 for 1996 and 1995, respectively. The
decrease in net investment income was primarily attributable to a decrease in
net investment spread, partially offset by lower investment and other expenses
and lower federal income tax expense.
Net investment spread decreased to $1.5 million during 1996 from $2.0
million in 1995. These amounts reflect net investment spread of 2.28% and 3.05%
during 1996 and 1995, respectively, between the Company's investment yield on
average cash and investments and the average rate credited on certificate
reserves. The Company's investment income decreased to $4.3 million from $4.9
million for 1996 and 1995, respectively. These amounts represent investment
yields of 7.78% and 8.29% on average cash and investments of $54.5 million and
$54.8 million for 1996 and 1995, respectively. This decrease in investment yield
on cash and investments was primarily attributable to a reduction in the average
duration of the investment portfolio during 1996 and to the December 1995 sale
of the Company's mortgage loan portfolio. The proceeds from the sale of mortgage
loans were invested in fixed maturities of a generally higher quality, but with
lower yields.
Interest credited on certificate reserves was $2.8 million and $2.9
million for 1996 and 1995, respectively. These amounts represent average rates
of interest credited of 5.50% and 5.24% on average certificate reserves of $50.4
million and $52.9 million for 1996 and 1995, respectively. New and renewal
contracts issued and outstanding during 1996 had crediting rates that were
generally higher than contracts that matured or surrendered during 1996,
resulting in the overall increase in the average crediting rate.
Investment and other expenses were $815,094 and $957,593 for 1996 and
1995, respectively. The decrease in investment and other expenses was primarily
attributable to the decrease in management and investment advisory fees.
Currently, management and investment advisory fees charged by ARM are computed
as a percentage of the Company's average certificate reserves and qualified
assets. Such fees were lower since the June 30, 1995 acquisition of the Company
primarily as a result of ARM's lower marginal operating cost attributable to
greater economies of scale.
Realized investment gains were $485,135 and $283,885 for 1996 and 1995,
respectively. These realized investment gains were interest-rate related and
attributable to the asset/liability management strategies of the Company.
Certificate reserves decreased $2.3 million or 4.3% during 1996, as
maturities and surrenders exceeded sales and renewals. The Company believes a
significant factor leading to the decrease was
8
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the certificate of deposit marketplace currently being very competitive, as many
financial institutions are offering special high rates to induce customers to
open new accounts. For face-amount certificates reaching their maturity date
during 1996 and 1995, 73% and 72%, respectively, were renewed.
Asset Portfolio Review
The Company primarily invests in securities with fixed maturities with the
objective of providing reasonable returns while limiting liquidity and credit
risks. The Company's investments in fixed maturities were 99% and 98% investment
grade for the years ended December 31, 1997 and 1996, respectively. Investment
grade securities are those classified as 1 or 2 by the National Association of
Insurance Commissioners, or where such classifications are not available,
securities are classified by a nationally recognized statistical rating
organization (i.e., Standard & Poor Corporation's rating of BBB- or above).
Additionally, the Company's investment portfolio has minimal exposure to real
estate, mortgage loans and common equity securities, which represented 0.8% and
1.0% of qualified assets at December 31, 1997 and 1996, respectively. As of
December 31, 1997, the Company held no securities which had defaulted on
principal or interest payments.
Fixed maturities include mortgage-backed and asset-backed securities,
corporate securities, U.S. Treasury securities and other government obligations.
Mortgage-backed securities ("MBSs"), which include pass-through securities and
collateralized mortgage obligations ("CMOs"), totaled $27.3 million at December
31, 1997, representing 54.2% of total qualified assets, net of unsettled
securities trades (58.9% at December 31, 1996). The Company's investments in
CMOs represented 52.4% and 52.8% of the Company's qualified assets, net of
unsettled securities trades, as of December 31, 1997 and 1996, respectively.
Currently, 76.9% of the CMOs are backed by the U.S. Government or U.S.
Government agencies. MBSs, including CMOs, are subject to risks associated
with prepayments of the underlying mortgage loans. Prepayments cause these
securities to have actual maturities different from those expected at the
time of purchase. The degree to which a security is susceptible to either an
increase or decrease in yield due to prepayment speed adjustments is
influenced by the difference between its amortized cost and par, the relative
sensitivity of the underlying mortgages backing the assets to prepayments in
a changing interest rate environment and the repayment priority of the
securities in the overall securitization structure. Prepayment sensitivity is
evaluated and monitored, giving full consideration to the collateral
characteristics such as weighted average coupon rate, weighted average
maturity and the prepayment history of the specific loan pool. Additionally,
the Company routinely projects three year liability and asset cash flows with
the goal of maintaining an adequate level of liquidity for maturing
face-amount certificates. The Company's asset/liability management strategies
not only allow the Company to monitor its short-term liquidity needs, but
also aim to provide protection to the investment portfolio from adverse
changes in interest rates.
Based on the provisions of Statement of Financial Accounting Standards
("SFAS") No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," the Company currently classifies its fixed maturity and equity
securities as available-for-sale. Such securities are carried at fair value and
changes in fair value, net of related deferred income taxes, are charged or
credited directly to shareholder's equity. Fluctuations in interest rates during
1997 resulted in unrealized gains of $54,723 (net of $29,466 in deferred income
taxes) at December 31, 1997 compared to unrealized gains of $231,541 (net of
$124,676 in deferred income taxes) at December 31, 1996. Volatility in reported
9
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shareholder's equity occurs as a result of SFAS No. 115 which requires some
assets to be carried at fair value while other assets and all liabilities are
carried at historical values.
The Company manages assets and liabilities in a closely integrated manner
to minimize the volatility of margins. As a result, adjusting the shareholder's
equity for changes in the fair value of the Company's fixed maturities and
equity securities without reflecting offsetting changes in the value of the
Company's liabilities or other assets creates volatility in reported
shareholder's equity but does not reflect the underlying economics of the
Company's business.
Liquidity and Financial Resources
The Company has never paid cash dividends on its common stock in order to
maintain and increase capital resources. The Company will, however, evaluate
this on an ongoing basis.
As of December 31, 1997, the Company had $14.6 million of qualified assets
in excess of the minimum amount required by the 1940 Act and the rules and
regulations promulgated thereunder by the SEC, as computed in accordance with
Section 28(b) of the 1940 Act. In addition, the MDC has certain regulatory
authority over the Company. The MDC has historically recommended to the Company
that face-amount certificate companies should maintain a ratio of shareholder's
equity to total assets of a minimum of 5% based upon a valuation of
available-for-sale securities reflected at amortized cost for purposes of this
calculation. Under this formula, the Company's capital ratio was 8.2% at
December 31, 1997.
The primary liquidity requirement of the Company relates to its payment of
certificate maturities and surrenders. The principal sources of cash to meet
such liquidity requirements are investment income and proceeds from maturities
and redemptions of investments.
At December 31, 1997, cash and cash equivalents totaled $13.1 million, an
increase of $9.9 million from December 31, 1996. The Company's aim is to manage
its cash and cash equivalents position so as to satisfy short-term liquidity
needs. In connection with this management of cash and cash equivalents, the
Company may invest idle cash in short duration fixed maturities to capture
additional yield when short-term liquidity requirements permit.
Cash flows of $4.0 million, $3.6 million and $4.1 million were generated
from operating activities in 1997, 1996 and 1995, respectively. These cash flows
resulted principally from investment income, less management and investment
advisory fees and commissions paid. Proceeds from sales, redemptions and
maturities of investments generated $93.1 million, $39.4 million and $51.8
million in cash flows during 1997, 1996 and 1995, respectively, which were
offset by purchases of investments of $79.5 million, $38.5 million and $44.2
million, respectively.
10
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Year 2000
During 1996, ARM completed an evaluation of all computer systems for Year
2000 compliance. Based on that initial review, it was determined that the
administration system which processes face- amount certificate transactions
could not accept Year 2000 data. The administration of face-amount certificates
is expected to be corrected or moved to a compliant system during 1998. This
Year 2000 compliance project, as it relates to the Company, is provided for
under the Administrative Services Agreement between ARM and the Company.
Item 8. Financial Statements and Supplementary Data
The Company's financial statements begin on page F-3. Reference is made to
the Index to Financial Statements on page F-1 herein. There is no additional
supplementary data filed herein.
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure
There have been no changes in or disagreements with accountants on
accounting, auditing, or financial reporting matters.
11
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PART III
Item 10. Directors and Executive Officers of the Registrant
This information is omitted in accordance with Instruction (I)(2)(c) to
Form 10-K.
Item 11. Executive Compensation
This information is omitted in accordance with Instruction (I)(2)(c) to
Form 10-K.
Item 12. Security Ownership of Certain Beneficial Owners and Management
This information is omitted in accordance with Instruction (I)(2)(c) to
Form 10-K.
Item 13. Certain Relationships and Related Transactions
This information is omitted in accordance with Instruction (I)(2)(c) to
Form 10-K.
12
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PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) Documents Filed as Part of this Report
1. Financial Statements.
See financial statements index on page F-1 of this document
for a listing of financial statements and reports of independent
auditors included in this report.
2. Financial Statement Schedules
The following financial statement schedules of the Company and
the related Report of Independent Auditors are incorporated herein
by reference and were previously filed as Part II Item 16(b) to Post
Effective Amendment No. 9 to Registration Statement on Form S-1 of
the Company to be filed on or about February 27, 1998 (File No.
33-38066):
Report of Independent Auditors
Schedule I Investments in Securities of Unaffiliated
Issuers--December 31, 1997
Schedule V Qualified Assets on Deposit--December 31, 1997
Schedule VI Certificate Reserves--Year Ended December 31, 1997
Schedule XII Valuation and Qualifying Accounts--December 31,
1997
Schedules I, V, and VI as of or for the year ended December
31, 1996 included in the Company's Post Effective Amendment No. 8 to
Registration Statement on Form S-1 filed February 28, 1997;
Schedules I, III, V and VI as of or for the year ended December 31,
1995 included in the Company's Post Effective Amendment No. 7 to
Registration Statement on Form S-1 filed March 5, 1996, are
incorporated herein by reference.
Schedules required by Article 6 of Regulation S-X for
face-amount certificate investment companies other than those listed
are omitted because they are not required, are not applicable, or
equivalent information has been included in the financial statements
and notes thereto, or elsewhere herein.
3. Exhibits
See Exhibit Index on page 14 of this report.
(b) Reports on Form 8-K
No reports on Form 8-K were filed by the Company during the fourth
quarter of 1997.
13
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SBM Certificate Company
Exhibit Index
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Exhibit
Number Description
- --------------------------------------------------------------------------------
3.1 Articles of Incorporation-filed as Exhibit 3(a) to Registration
Statement No. 33-38066 dated December 4, 1990.*
3.2 By-laws-filed as Exhibit 3(b) to Registration Statement No. 33-38066
dated December 4, 1990.*
4 Instruments defining the rights of security holders-Form of Series
503 Certificate filed as Exhibit 4 to Registration Statement on Form
N-8B-4, File No. 811-6268, filed April 1, 1991.*
10.1 Underwriting Agreement by and between the Company and SBM Financial
Services, Inc. dated June 14, 1995, filed as Exhibit 10(b) to
Amendment No. 7 to Registration Statement No. 33-38066 of the
Company dated March 5, 1996.*
10.2 Administrative Services Agreement by and between the Company and ARM
Financial Group, Inc. dated as of June 14, 1995, filed as Exhibit
10(c) to Amendment No. 7 to Registration Statement No. 33-38066 of
the Company dated March 5, 1996.*
10.3 Investment Services Agreement by and between the Company and ARM
Financial Group, Inc. dated as of June 14, 1995, filed as Exhibit
10(d) to Amendment No. 7 to Registration Statement No. 33-38066 of
the Company dated March 5, 1996.*
10.4 Custody Agreement, as amended and supplemented, between the Company
and First Trust National Association dated December 20, 1990, filed
as Exhibit 10(b) to Amendment No. 1 to Registration Statement No.
33-38066 of the Company dated January 2, 1991.*
10.5 Lease between the Company and State Bank & Trust Company of New Ulm
dated August 13, 1992, filed as Exhibit 10A to Form 10-K of SBM
Company filed March 31, 1993 (File No. 811-407).*
10.6 Form of Tax Allocation Agreement by and among the Company, ARM
Financial Group, Inc. and certain ARM subsidiaries dated March 21,
1996, filed as Exhibit 10.1 to Form 10-Q of the Company, File No.
811- 6268, filed May 14, 1996.*
10.7 Policies on Asset/Liability Risk Management and Investment
Management by and among the Company, adopted as of March 19, 1997,
files as Exhibit 10(g) to Form S-1 Registration Statement of the
Company (File No. 33-38066).*
10.8 Indemnification Agreement by and between the Company and ARM
Financial Group, Inc. dated June 26, 1997, filed as Exhibit 10(h) to
Form S-1 Registration Statement of the Company (File No. 33-38066).*
23.1 Consent of Ernst & Young LLP, filed herewith.
27 Not applicable.
* Previously filed as indicated and incorporated herein by
reference.
14
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SIGNATURES
Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on February 26, 1998.
SBM Certificate Company
By: /s/ JOHN R. McGEENEY
----------------------------------
John R. McGeeney
Chairman of the Board of Directors
and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant in the capacities indicated on the 26th day of February 1998.
Name Title
---- -----
/s/ JOHN R. McGEENEY Chairman of the Board of Directors
- ---------------------------------- and President (Principal Executive Officer)
John R. McGeeney
/s/ EDWARD L. ZEMAN Executive Vice President-Chief Financial
- ---------------------------------- Officer (Principal Financial Officer)
Edward L. Zeman
/s/ BARRY G. WARD Controller (Principal Accounting Officer)
- ----------------------------------
Barry G. Ward
/s/ STEVEN B. BING Director
- ----------------------------------
Steven B. Bing
/s/ THEODORE S. ROSKY Director
- ----------------------------------
Theodore S. Rosky
/s/ WALTER L. SALES Director
- ----------------------------------
Walter L. Sales
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SBM Certificate Company
Index to Financial Statements
Report of Independent Auditors...............................................F-2
Balance Sheets as of December 31, 1997 and 1996..............................F-3
Statements of Operations for the Years Ended
December 31, 1997, 1996, and 1995.........................................F-5
Statements of Shareholder's Equity for the Years Ended
December 31, 1997, 1996 and 1995..........................................F-6
Statements of Cash Flows for the Years Ended
December 31, 1997, 1996 and 1995..........................................F-7
Notes to Financial Statements................................................F-8
F-1
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Report of Independent Auditors
Board of Directors
SBM Certificate Company
We have audited the accompanying balance sheets of SBM Certificate Company as of
December 31, 1997 and 1996, and the related statements of income, shareholder's
equity, and cash flows for each of the three years in the period ended December
31, 1997. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of SBM Certificate Company at
December 31, 1997 and 1996, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1997, in conformity
with generally accepted accounting principles.
/s/ Ernst & Young LLP
Louisville, Kentucky
February 9, 1998
F-2
<PAGE>
SBM Certificate Company
Balance Sheets
<TABLE>
<CAPTION>
================================================================================
December 31,
1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C>
Assets
Qualified assets:
Cash and investments:
Investments in securities of unaffiliated issuers:
Fixed maturities available-for-sale, at fair
value (amortized cost: 1997-$45,602,442;
1996-$49,863,826) $45,614,870 $50,169,361
Equity securities, at fair value
(cost: 1997-$340,473; 1996-$493,912) 412,234 544,594
Certificate loans 186,292 273,368
Other invested assets 471,992 523,083
Cash and cash equivalents 13,054,864 3,247,192
-------------------------
Total cash and investments 59,740,252 54,757,598
Receivables:
Dividends and interest 328,516 533,958
Receivable for investment securities sold -- 122,570
-------------------------
Total receivables 328,516 656,528
-------------------------
Total qualified assets 60,068,768 55,414,126
Deferred acquisition cost 157,994 132,163
Goodwill -- 113,095
Other assets 42,948 66,163
-------------------------
Total assets $60,269,710 $55,725,547
=========================
</TABLE>
F-3
<PAGE>
SBM Certificate Company
Balance Sheets (Continued)
<TABLE>
<CAPTION>
================================================================================
December 31,
1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C>
Liabilities and shareholder's equity
Liabilities:
Certificate reserves $45,127,084 $50,186,386
Payable for investment securities purchased 9,731,948 --
Deferred federal income taxes 98,320 445,419
Accounts payable and other liabilities 330,686 29,940
-------------------------
Total liabilities 55,288,038 50,661,745
Shareholder's equity:
Common stock, $1 par value; 1,000,000 shares
authorized; 250,000 shares issued and
outstanding 250,000 250,000
Additional paid-in capital 3,050,000 3,050,000
Net unrealized gains on available-for-sale
securities 54,723 231,541
Retained earnings 1,626,949 1,532,261
-------------------------
Total shareholder's equity 4,981,672 5,063,802
-------------------------
Total liabilities and shareholder's equity $60,269,710 $55,725,547
=========================
</TABLE>
See accompanying notes.
F-4
<PAGE>
SBM Certificate Company
Statements of Operations
<TABLE>
<CAPTION>
=======================================================================================================
Year Ended December 31,
-----------------------------------------
1997 1996 1995
- -------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Investment income:
Interest income from securities $ 3,729,295 $ 4,089,948 $ 4,276,460
Interest income from mortgage loans -- -- 366,321
Other investment income 203,810 200,127 246,597
-----------------------------------------
Total investment income 3,933,105 4,290,075 4,889,378
Investment and other expenses:
Management and investment advisory fees 246,468 246,468 358,486
Deferred acquisition cost amortization and renewal
commissions 288,974 245,126 289,875
Real estate expenses 166,670 205,029 137,777
Amortization of goodwill 23,833 79,824 92,248
Other expenses 29,311 38,647 79,207
-----------------------------------------
Total investment and other expenses 755,256 815,094 957,593
Interest credited on certificate reserves 2,795,360 2,821,912 2,929,357
-----------------------------------------
Net investment income before federal
income taxes 382,489 653,069 1,002,428
Federal income tax expense (124,284) (238,399) (407,074)
-----------------------------------------
Net investment income 258,205 414,670 595,354
Realized investment gains (losses) (268,002) 485,135 283,885
Federal income tax benefit (expense) on realized investment
gains and losses 104,485 (167,824) (102,500)
-----------------------------------------
Net realized investment gains (losses) (163,517) 317,311 181,385
-----------------------------------------
Net income $ 94,688 $ 731,981 $ 776,739
=========================================
</TABLE>
See accompanying notes.
F-5
<PAGE>
SBM Certificate Company
Statements of Shareholder's Equity
<TABLE>
<CAPTION>
================================================================================================================
Net
Unrealized
Gains (Losses)
Additional on Available- Total
Common Paid-In For-Sale Retained Shareholder's
Stock Capital Securities Earnings Equity
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1995 $ 250,000 $ 3,740,006 $(4,242,659) $ 439,576 $ 186,923
Net income 776,739 776,739
Capital contribution from SBM Life 1,500,000 1,500,000
Purchase accounting adjustment
(Note 2) (2,190,006) 1,066,442 (416,035) (1,539,599)
Change in net unrealized losses on
available-for-sale securities 4,062,095 4,062,095
-----------------------------------------------------------------------
Balance, December 31, 1995 250,000 3,050,000 885,878 800,280 4,986,158
Net income 731,981 731,981
Change in net unrealized gains
(losses) on available-for-sale
securities (654,337) (654,337)
-----------------------------------------------------------------------
Balance, December 31, 1996 250,000 3,050,000 231,541 1,532,261 5,063,802
Net income 94,688 94,688
Change in net unrealized gains on
available-for-sale securities (176,818) (176,818)
-----------------------------------------------------------------------
Balance, December 31, 1997 $ 250,000 $ 3,050,000 $ 54,723 $ 1,626,949 $ 4,981,672
=======================================================================
</TABLE>
See accompanying notes.
F-6
<PAGE>
SBM Certificate Company
Statements of Cash Flows
<TABLE>
<CAPTION>
============================================================================================================
Year Ended December 31,
--------------------------------------------
1997 1996 1995
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Cash flows provided by (used in) operating activities:
Net income $ 94,688 $ 731,981 $ 776,739
Adjustments to reconcile net income to cash flows provided
by operating activities:
Provision for certificate reserves 2,795,360 2,821,912 2,929,357
Realized investment (gains) losses 268,002 (485,135) (283,885)
Deferral of acquisition costs (314,805) (263,788) (430,852)
Amortization of deferred acquisition costs and
renewal commissions 288,974 245,126 289,875
Other amortization and depreciation 465,553 530,429 228,861
Deferred tax expense (benefit) (162,627) 178,606 295,464
(Increase) decrease in dividends and interest receivable 205,442 (136,060) 34,571
Changes in other assets and liabilities 323,093 (40,816) 250,559
--------------------------------------------
Cash flows provided by operating activities 3,963,680 3,582,255 4,090,689
Cash flows provided by (used in) investing activities:
Fixed maturity investments:
Purchases (79,455,679) (38,523,432) (44,224,876)
Maturities and redemptions 10,812,744 5,642,891 2,678,900
Sales 82,250,553 33,578,496 44,977,473
Sales, maturities and redemptions--mortgage loans 3,091 155,643 4,192,459
Additions to other invested assets -- -- (81,200)
Repayment of certificate loans, net 87,076 6,095 59,416
--------------------------------------------
Cash flows provided by investing activities 13,697,785 859,693 7,602,172
Cash flows provided by (used in) financing activities:
Amounts paid to face-amount certificate holders (8,179,248) (6,063,787) (13,322,027)
Amounts received from face-amount certificate holders 325,456 968,537 2,498,761
Capital contribution -- -- 1,500,000
--------------------------------------------
Cash flows used in financing activities (7,853,792) (5,095,250) (9,323,266)
--------------------------------------------
Net change in cash and cash equivalents 9,807,673 (653,302) 2,369,595
Cash and cash equivalents at beginning of year 3,247,192 3,900,494 1,530,899
--------------------------------------------
Cash and cash equivalents at end of year $ 13,054,865 $ 3,247,192 $ 3,900,494
============================================
</TABLE>
See accompanying notes.
F-7
<PAGE>
SBM Certificate Company
Notes to Financial Statements
1. Organization and Significant Accounting Policies
Organization
SBM Certificate Company (the "Company") was incorporated in 1990 for the
purpose of acquiring the face-amount certificate business of SBM Company
("SBM"). Effective December 31, 1993, SBM transferred all of the Company's
shares of common stock to its wholly owned subsidiary, State Bond and Mortgage
Life Insurance Company ("SBM Life"), and the Company became a wholly owned
subsidiary of SBM Life.
On June 14, 1995, ARM Financial Group, Inc. ("ARM"), completed the
acquisition of substantially all of the assets and business operations of SBM,
including all of the issued and outstanding common stock of SBM's subsidiaries,
SBM Life and SBM Financial Services, Inc (the "Acquisition"). On November 29,
1996, SBM Financial Services, Inc. changed its name to ARM Securities
Corporation ("ARM Securities"). By virtue of the Acquisition, ARM acquired
control of the Company, a wholly owned subsidiary of SBM Life. Concurrent with
the Acquisition, ARM acquired all outstanding shares of the authorized common
stock of the Company from SBM Life for a purchase price of $3.3 million.
Nature of Operations
The Company is an issuer of face-amount certificates and is registered
under the Investment Company Act of 1940 (the "1940 Act"). A face-amount
certificate is an obligation of the Company requiring the Company to pay
certificate holders the original invested amount of the certificate, plus a
three-year fixed-rate return, at a given maturity date. The Company's
face-amount certificates are sold primarily in the Midwest. Face-amount
certificates, which are similar to bank certificates of deposit, generally
compete with various types of individual savings products offered by banks and
insurance companies that provide a fixed rate of return on investors' money.
Basis of Presentation
The financial statements are prepared in accordance with generally
accepted accounting principles. The 1995 financial statements reflect purchase
accounting adjustments related to the Acquisition (see Note 2).
Investments
Fixed maturities and equity securities are classified as
available-for-sale. Available-for-sale securities are stated at fair value, with
the unrealized gains and losses, net of taxes, reported as a separate component
of shareholder's equity in accordance with Statement of Financial Accounting
Standards ("SFAS") No. 115, "Accounting for Certain Investments in Debt and
Equity Securities." The amortized cost of fixed maturities classified as
available-for-sale is adjusted for amortization of premiums and accretion of
discounts to maturity, or in the case of mortgage-backed securities, over the
estimated life of the security. Such amortization or accretion is computed using
the interest
F-8
<PAGE>
method and is included in investment income. Anticipated prepayments on
mortgage-backed securities are considered in determining the effective yield on
such securities. If a difference arises between anticipated and actual
prepayments, the carrying value of the investment is adjusted with a
corresponding charge or credit to investment income. Interest and dividends are
included in investment income. Certificate loans are carried at their unpaid
principal balances. Cash and cash equivalents consist of highly liquid
investments with maturities of three months or less from the time of purchase.
Security transactions are accounted for on the date the order to buy or sell is
executed. Realized gains and losses on the sale of investments are determined
based upon the specific identification method.
Other invested assets includes real estate, which is recorded at cost,
less accumulated depreciation since the Acquisition.
Deferred Acquisition Costs
Costs of issuing new face-amount certificates, principally commissions,
have been deferred. These costs are amortized on a straight-line basis over the
initial maturity period of the certificates which is three years.
Face-Amount Certificate Reserves
Face-amount certificates issued by the Company entitle certificate
holders, who have made either single or installment payments, to receive a
definite sum of money at maturity. Certificate reserves accrue interest, and
cash surrender values are less than accumulated certificate reserves prior to
maturity dates. The reserve accumulation rates, cash surrender values, and
certificate reserves, among other matters, are governed by the 1940 Act.
Income Taxes
In accordance with SFAS No. 109, "Accounting for Income Taxes", the
Company uses the liability method of accounting for income taxes. The Company's
taxable income or loss is included in the consolidated federal income tax return
of ARM. The Company provides for income taxes based on a proportionate share of
consolidated taxable income. Additionally, tax benefits are recognized for
losses to the extent they can be used in the consolidated return. It is the
Company's and ARM's policy that any tax benefit recorded by one entity will be
reimbursed by the benefitted entity.
Use of Estimates
The preparation of financial statements in conformity with generally
accepted accounting principles requires management of the Company to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
F-9
<PAGE>
2. Acquisition of the Company
The Acquisition was accounted for using the purchase method of accounting.
Under purchase accounting, assets and liabilities are adjusted to their
estimated fair value and reflect an allocation of the Company's portion of the
cost of the Acquisition, commonly referred to as "push-down accounting."
The purchase accounting adjustment reflected in the accompanying statement
of shareholder's equity for the year ended December 31, 1995 was recorded on May
31, 1995, the effective date of the Acquisition. The adjustment restated
shareholder's equity on that date to $3.3 million, the purchase price allocated
to the Company by ARM. The December 31, 1995, balances for "retained earnings"
and "net unrealized gains on available-for-sale securities" reflect net income
and the change in the fair value of fixed maturities and equity securities
subsequent to the Acquisition.
The following combined condensed statements of operations and cash flows
present results for the five months ended May 31, 1995, prior to the
Acquisition, and the seven months ended December 31, 1995, following the
Acquisition. The combined amounts agree to the accompanying statements of
operations and cash flows for the year ended December 31, 1995. The operating
results subsequent to the Acquisition include the effect of new accounting
values assigned to invested assets and intangibles and differing asset/liability
management strategies and expense allocation methodologies of ARM and SBM
management.
F-10
<PAGE>
<TABLE>
<CAPTION>
Seven
Months
Five Months Ended Year Ended
Ended December 31, December 31,
May 31, 1995 1995 1995
--------------------------------------------------
<S> <C> <C> <C>
Combined Condensed Statement of Operations:
Total investment income $ 2,013,780 $ 2,875,598 $ 4,889,378
Total investment and other expenses 511,343 446,250 957,593
Interest credited on certificate reserves 1,224,738 1,704,619 2,929,357
--------------------------------------------------
Net investment income before federal income taxes 277,699 724,729 1,002,428
Federal income tax expense (94,000) (313,074) (407,074)
--------------------------------------------------
Net investment income 183,699 411,655 595,354
Realized investment gains (losses) (314,000) 597,885 283,885
Federal income tax benefit (expense) on realized
investment gains and losses 106,760 (209,260) (102,500)
--------------------------------------------------
Net income (loss) $ (23,541) $ 800,280 $ 776,739
==================================================
Combined Condensed Statement of Cash Flows:
Cash flows provided by operating activities $ 1,462,487 $ 2,628,202 $ 4,090,689
Cash flows provided by (used in) investing activities:
Fixed maturity investments:
Purchases (21,615) (44,203,261) (44,224,876)
Maturities and redemptions 903,084 1,775,816 2,678,900
Sales 5,090,653 39,886,820 44,977,473
Sales, maturities and redemptions-- mortgage loans 392,947 3,799,512 4,192,459
Additions to other invested assets, net (81,200) -- (81,200)
Repayments of certificate loans, net 66,731 (7,315) 59,416
--------------------------------------------------
Cash flows provided by investing activities 6,350,600 1,251,572 7,602,172
Cash flows provided by (used in) financing activities:
Amounts paid to face-amount certificate holders (7,066,042) (6,255,985) (13,322,027)
Amounts received from face-amount certificate
holders 1,926,095 572,666 2,498,761
Capital contribution from SBM Life 1,500,000 -- 1,500,000
--------------------------------------------------
Cash flows used in financing activities (3,639,947) (5,683,319) (9,323,266)
--------------------------------------------------
Net change in cash and cash equivalents 4,173,140 (1,803,545) 2,369,595
Cash and cash equivalents at beginning of period 1,530,899 5,704,039 1,530,899
--------------------------------------------------
Cash and cash equivalents at end of period $ 5,704,039 $ 3,900,494 $ 3,900,494
==================================================
</TABLE>
F-11
<PAGE>
3. Investments
The amortized cost and estimated fair values of available-for-sale
securities were as follows:
<TABLE>
<CAPTION>
Available-for-Sale Securities
--------------------------------------------------------------
Gross Gross
Unrealized Unrealized Estimated
Cost Gains Losses Fair Value
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
December 31, 1997:
Fixed maturities:
U.S. Treasury securities and
obligations of U.S. government
agencies $11,343,142 $ 11,763 $ 2,985 $11,351,920
Obligations of state and political
subdivisions 387,196 12,225 -- 399,421
Foreign governments 450,960 -- 49,052 401,908
Corporate securities 5,102,468 40,992 -- 5,143,460
Asset-backed securities 1,033,932 -- 2,372 1,031,560
Mortgage-backed securities 27,284,744 121,331 119,474 27,286,601
--------------------------------------------------------------
Total fixed maturities 45,602,442 186,311 173,883 45,614,870
Equity securities 340,473 73,277 1,516 412,234
--------------------------------------------------------------
Total available-for-sale securities $45,942,915 $ 259,588 $ 175,399 $46,027,104
==============================================================
December 31, 1996:
Fixed maturities:
U.S. Treasury securities and
obligations of U.S. government
agencies $ 3,467,777 $ -- $ 38,359 $ 3,429,418
Obligations of state and political
subdivisions 456,112 3,498 8,838 450,772
Foreign governments 951,123 13,000 5,893 958,230
Corporate securities 7,569,178 63,776 15,206 7,617,748
Asset-backed securities 5,131,230 3,763 35,468 5,099,525
Mortgage-backed securities 32,288,406 498,888 173,626 32,613,668
--------------------------------------------------------------
Total fixed maturities 49,863,826 582,925 277,390 50,169,361
Equity securities 493,912 53,270 2,588 544,594
--------------------------------------------------------------
Total available-for-sale securities $50,357,738 $ 636,195 $ 279,978 $50,713,955
==============================================================
</TABLE>
F-12
<PAGE>
The amortized cost and estimated fair value of securities by contractual
maturity are shown below. Expected maturities will differ from contractual
maturities because borrowers may have the right to call or repay obligations
with or without call or prepayment penalties and because mortgage-backed and
asset-backed securities provide for periodic payments throughout their life.
December 31, 1997
----------------------------
Estimated
Fair
Cost Value
- --------------------------------------------------------------------------------
Available-for-sale:
Due in one year or less $ 2,541,168 $ 2,549,592
Due after one year through five years 14,269,221 14,247,246
Due after five years through ten years 161,745 168,915
Due after ten years 225,450 230,506
Asset-backed securities 1,033,932 1,031,560
Mortgage-backed securities 27,284,744 27,286,601
Redeemable preferred stock 86,182 100,450
----------------------------
Total fixed maturities $45,602,442 $45,614,870
============================
Gross gains of $765,664, $642,039, $815,733, and $7,399 and gross losses
of $1,082,809, $175,226, $148,041, and $321,399 were realized on sales of fixed
maturities classified as available- for-sale for the year ended December 31,
1997 and 1996, the seven months ended December 31, 1995 and the five months
ended May 31, 1995, respectively.
Gross gains of $49,143, $23,980 and zero were recognized on equity
securities sold during 1997, 1996, and 1995, respectively. Gross losses of zero
for both 1997 and 1996, and $5,075 for 1995 were recognized on equity securities
sold. Gross losses of $64,732 were realized on the sale of substantially all
mortgage loans in December 1995.
F-13
<PAGE>
4. Certificate Reserves
Total certificate reserves at December 31 are summarized as follows:
<TABLE>
<CAPTION>
Minimum Additional
1997 1996 Interest Interest
----------------------------------------------------------------------
<S> <C> <C> <C> <C>
Fully-paid certificates:
Single-payment series 503 $ 41,533,024 $ 46,302,625 2.50% 1.85% to 4.60%
Installment 2,220,962 2,270,515 2.50% to 3.50% 1.50% to 2.75%
Optional settlement 521,643 592,513 2.50% to 3.00% 2.00% to 2.75%
Due to unlocated certificate
holders 2,878 2,878 None
------------------------------
44,278,507 49,168,531
Installment certificates:
Reserves to mature, by series:
120, 215, and 220 393,801 424,651 3.25% 1.75% to 2.00%
315 191,975 296,064 3.50% 1.50% to 1.75%
Advance payments 262,801 297,140 * *
------------------------------
848,577 1,017,855
------------------------------
Total certificate reserves $ 45,127,084 $ 50,186,386
==============================
</TABLE>
* Minimum interest rates on advance payments are generally the same as
the rates on scheduled installment payments. Interest credited on
advance payments, however, is accruing at 5.00% and will continue at
that rate through 1998.
5. Fair Values of Financial Instruments
The following disclosure of the estimated fair values of financial
instruments is made in accordance with the requirements of SFAS No. 107,
"Disclosures About Fair Value of Financial Instruments." The estimated fair
value amounts have been determined using available market information and
appropriate valuation methodologies. However, considerable judgement was
required to develop these estimates. Accordingly, the estimates are not
necessarily indicative of the amounts which could be realized in a current
market exchange. The use of different market assumptions or estimation
methodologies may have a material effect on the estimated fair value amounts.
F-14
<PAGE>
<TABLE>
<CAPTION>
December 31, 1997 December 31, 1996
--------------------------------------------------------------
Carrying Estimated Carrying Estimated
Value Fair Value Value Fair Value
- -------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Assets:
Investments in securities of unaffiliated issuers:
Fixed maturities available-for-sale $45,614,870 $45,614,870 $50,169,361 $50,169,361
Equity securities 412,234 412,234 544,594 544,594
Certificate loans 186,292 186,292 273,368 273,368
Other invested assets 471,992 471,992 523,083 523,083
Cash and cash equivalents 13,054,864 13,054,864 3,247,192 3,247,192
Other assets 42,948 42,948 66,163 66,163
Liabilities:
Certificate reserves 45,127,084 45,340,626 50,186,386 50,767,396
Accounts payable and other liabilities 330,686 330,686 29,940 29,940
</TABLE>
The following methods and assumptions were used in estimating fair values:
Investments in Securities of Unaffiliated Issuers
Fair values for investments in securities of unaffiliated issuers are
based on quoted market prices, where available. For investments in securities of
unaffiliated issuers for which a quoted market price is not available, fair
values are estimated using internally calculated estimates or quoted market
prices of comparable instruments.
Certificate Loans
The carrying value of certificate loans approximates their fair value.
Cash and Cash Equivalents
The carrying amounts of cash and cash equivalents approximate their fair
value given the short-term nature of these assets.
Certificate Reserves
The fair value of certificate reserves is based on a discounted cashflow
analysis, using the current interest rate offered on new certificates of 5.25%
at December 31, 1997 and 1996.
Other Invested Assets, Other Assets, Accounts Payable and Other Liabilities
The financial statement carrying amounts of other invested assets, other
assets, accounts payable and other liabilities are deemed to be a reasonable
approximation of their fair value.
F-15
<PAGE>
6. Federal Income Taxes
Deferred federal income taxes reflect the net tax effects of (i) temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes, and (ii)
operating and capital losses. Significant components of the deferred tax
liabilities and assets as of December 31, 1997 and December 31, 1996 were:
<TABLE>
<CAPTION>
December 31,
-------------------------
1997 1996
- ---------------------------------------------------------------------------------------------------
<S> <C> <C>
Deferred tax liabilities:
Real estate limited partnership $ 99,798 $ 178,736
Net unrealized gains on available-for-sale securities 29,466 124,676
Other 2,932 --
-------------------------
Total deferred tax liabilities 132,196 303,412
Deferred tax assets:
Fixed maturities 19,568 45,524
Other investments 93,789 93,789
Fixed assets 38,677 38,149
Capital loss carryover 281,842 363,267
Other -- 31,785
-------------------------
Total deferred tax assets 433,876 572,514
Valuation allowance for deferred tax assets (400,000) (714,521)
-------------------------
Net deferred tax assets 33,876 (142,007)
-------------------------
Deferred tax liabilities shown on the accompanying balance sheets $ 98,320 $ 445,419
=========================
</TABLE>
The components of the provision for federal income tax expense consist of the
following:
Year Ended December 31,
----------------------------------------
1997 1996 1995
----------------------------------------
Current $ 182,426 $ 227,617 $ 214,110
Deferred (162,627) 178,606 295,464
----------------------------------------
Total federal income tax expense $ 19,799 $ 406,223 $ 509,574
========================================
Current and deferred federal income tax expenses for the seven months
ended December 31, 1995 were $233,870 and $288,464, respectively. For the five
months ended May 31, 1995 the current tax benefit was $19,760 and the deferred
tax expense was $7,000.
F-16
<PAGE>
In the event that future tax assets are recognized on deductible temporary
differences for which a valuation allowance was provided at the Acquisition
date, such benefits are applied to first reduce the balance of goodwill. During
1997 and 1995, goodwill was reduced by $89,262 and $189,251, respectively, as a
result of realizing such benefits. No such benefits were realized in 1996. The
1997 reduction in the valuation allowance of $314,521 reduced the goodwill
balance to zero.
Federal income tax expense differs from that computed by using the federal
income tax rate of 35% as shown below.
<TABLE>
<CAPTION>
Seven Months Five Months
Year Ended December 31, Ended Ended
----------------------------------------- December 31, May 31,
1997 1996 1995 1995 1995
-------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Income tax expense (benefit) at
statutory rate $ 40,070 $ 398,371 $ 450,209 $ 462,915 $ (12,706)
Tax-exempt interest (5,677) (7,283) (7,256) (3,350) (3,906)
Dividend received deduction (12,457) (12,577) (14,379) (8,000) (6,379)
Goodwill amortization 8,342 27,938 32,287 32,287 --
Taxable proceeds from life
insurance -- -- 38,482 38,482 --
Other (10,479) (226) 10,231 -- 10,231
-------------------------------------------------------------------------
Total federal income tax expense
(benefit) $ 19,799 $ 406,223 $ 509,574 $ 522,334 $ (12,760)
=========================================================================
</TABLE>
The Company files a consolidated federal income tax return with its
non-life insurance affiliates. Pursuant to the tax sharing agreement, the
consolidated income tax liability is allocated among the companies based upon
each members' proportionate share of taxable income with current credit being
given for losses utilized against other members' taxable income. The allocated
tax liabilities are settled timely upon the completion of the annual
consolidated federal return. At December 31, 1997 and 1996, $124,435 and
$213,902 were due to ARM, respectively, related to the tax sharing agreement.
7. Related Party Transactions
For the periods presented, management and investment advisory fee expenses
reflected in the accompanying financial statements represent allocations of
expenses from SBM and ARM for the respective periods prior and subsequent to the
Acquisition. These allocations include amounts for administrative and investment
services, including use of property, equipment and facilities. The allocations
are currently based on the proportion which such business and assets managed
represents of all of ARM's and its subsidiaries' business activities. Prior to
the Acquisition, the allocations were primarily based on the amount of time
spent by SBM employees on the face-amount certificate business and on the
proportion which such business represents of all of SBM's and its subsidiaries'
business activities. The allocations were $246,468 for both the years ended
December 31, 1997 and 1996, $151,967 and $206,519 for the seven months ended
December 31, 1995 and the five months
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<PAGE>
ended May 31, 1995, respectively. Management believes that the methods used to
allocate such expenses are reasonable. The Company owns and pays operating
expenses for a building used by SBM (prior to the Acquisition) and its
affiliates.
The Company has paid ARM Securities, an affiliate, $314,805, $263,089 and
$443,579 for the years ended 1997, 1996 and 1995, respectively, for sales
commissions and other issuance, underwriting, and sales expenses.
8. Shareholder's Equity and Regulatory Matters
The Company is subject to two principal restrictions relating to its
regulatory capital requirements. First, under the 1940 Act, the Company is
required to establish and maintain qualified assets (as defined in Section 28(b)
of the 1940 Act) having a value not less than the aggregate of certificate
reserves plus $250,000 ($45.4 million and $50.4 million at December 31, 1997 and
1996, respectively). The Company had qualified assets of $60.0 million and $55.1
million at those respective dates (which excludes $0.1 million and $0.4 million,
respectively, of unrealized pretax gains on fixed maturities and equity
securities classified as available-for-sale).
For purposes of determining compliance with the foregoing provisions,
qualified assets are valued in accordance with District of Columbia Insurance
Laws (the "D.C. Laws") as required by the 1940 Act. Qualified assets for which
no provision for valuation is made in the D.C. Laws are valued in accordance
with rules, regulations, or orders prescribed by the Securities and Exchange
Commission. These values are the same as the financial statement carrying
values, except that for financial statement purposes, fixed maturities and
equity securities classified as available-for-sale are carried at fair value.
For qualified asset purposes, fixed maturities classified as available-for-sale
are valued at amortized cost and equity securities are valued at cost.
Second, the Minnesota Department of Commerce ("MDC") has historically
recommended to the Company that face-amount certificate companies should
maintain a ratio of shareholder's equity to total assets of a minimum of 5%
based upon a valuation of available-for-sale securities at amortized cost for
purposes of this calculation. Under this formula, the Company's capital ratio
was 8.2% and 8.7% at December 31, 1997 and 1996, respectively. In November 1994,
based on the decline in the value of the Company's investment portfolio,
resulting from increasing interest rates in 1994 and the Company's decreasing
liquidity resulting from reduced principal payments on the Company's
collateralized mortgage obligations portfolio, the MDC recommended that the
Company increase its capital level. The MDC's concern was influenced by the
Company's capital ratio, calculated including the effects of unrealized
investment losses. Therefore, on March 29, 1995, SBM Life, the former parent
company of the Company, made a $1.5 million capital contribution to the Company.
Pursuant to the required calculations of various states, the provisions of
the certificates, depository agreements, and the 1940 Act, qualified assets of
the Company were deposited with independent custodians to meet certificate
liability requirements as of December 31, 1997 and 1996 as shown in the
following table. Certificate loans, secured by applicable certificate reserves,
are deducted from certificate reserves in computing deposit requirements.
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<PAGE>
1997 1996
-------------------------
Assets on deposit with:
Central depositary $48,664,004 $51,522,592
State governmental authorities 245,772 245,102
-------------------------
Total deposits $48,909,776 $51,767,694
=========================
Required deposits (certificate reserves
less certificate loans plus $250,000 $45,190,792 $50,163,018
=========================
Assets on deposit consisted of the following at December 31:
1997 1996
-------------------------
Investment securities, at cost plus accrued interest $48,437,784 $51,244,584
First mortgage loans 960 4,068
Other assets on deposit, at cost 471,032 519,042
-------------------------
Total deposits $48,909,776 $51,767,694
=========================
F-19
<PAGE>
Exhibit 23.1
Consent of Independent Auditors
We consent to the incorporation by reference in this Annual Report (Form 10-K)
of SBM Certificate Company for the year ended December 31, 1997, of our report
dated February 9, 1998, included in Post Effective Amendment No. 9 to the
Registration Statement (Form S-1 No. 33-38066) and related Prospectus
("Registration Statement"), with respect to the financial statement schedules of
SBM Certificate Company listed in Item 16(b) of the Registration Statement.
/s/ Ernst & Young LLP
Louisville, Kentucky
February 23, 1998
